Economic Logic, Too

About Me

I discuss recent research in Economics and various events from an economic perspective, as the name of the blog indicates. I plan on adding posts approximately every workday, with some exceptions, for example when I travel.

Tuesday, May 31, 2011

While the minimum wage is seen by many as an easy way to prevent poverty, it has its pitfalls. Apart from the fact that it may increase unemployment, it may lower wages and attract more immigrants. Now add to this that minimum wages may decrease disposable income and thus consumption.

Mirco Tonin looks at the case of a country with a significant underground economy. As only declared labor income is taxed, introducing a minimum wages means that everyone must declare at least the minimum wage as income. For at least some people this will reduce disposable income. Now increase that minimum wage, then everyone who was declaring such an income has to pay more taxes. Is this significant? Tonin looks at Hungary where there was a significant increase in the minimum wage in 2001 and it is believed half of those declaring minimum wage on their tax return actually earn more. Looking at the gap between consumption and income on household data, a common way to identify underground income, he finds that the effect on consumption was quite significant for those who were affected by the minimum wage hike.

Monday, May 30, 2011

Critics have had a field day the past couple of years claiming that Economics is not up to the task because its models are too abstract. Macroeconomics has been especially affected because the trigger of the bandwagon was a macroeconomic event, the now Great Recession. I have discussed a few bad attempts at criticism, which were usually bad because ill-informed and because they could not offer any viable alternative.

The latest salvo comes from Hashem Pesaran and Ron Smith. They have several arguments. The first is that macroeconomic modeling of the DSGE brand insists too much on internal consistency and should allow more degrees of freedom to fit the data. Pesaran and Smith should first specify what the goal of the model is before criticizing the approach. If it is short-term forecasting, then go ahead with a purely statistical approach on macro data. If you want policy advice, you need something that withstands the Lucas Critique, and strong micro-foundations is then the way to go. But without a given purpose, any criticism is moot.

Pesaran and Smith, given their track record, are of course strong advocates of purely statistical methods. Throw every possible series in a regression, and see what sticks. I am not saying this cannot be useful, it allows to establish relationships in the data and I regularly report on such results, but this does not allow you to explain things. For this, you need some structure and theory provides you that. This brings me to the title of this post. There appears to be some disagreement about the meaning of the word "model." To me, model is a set of relationships established by theory that can then be used on data, for policy experiments, etc. For Pesaran and Smith, a model is a set of aggregate data series that are used in a statistical analysis of some kind (VAR, non-parametric, etc.). If we cannot agree what we are talking about, of course there will be endless and fruitless discussions.

For example, they are not the first to criticize DSGE models for failing to include housing, finance and the external sector. Well, models (the way I see them) are abstractions, and you do not want to include everything them, or you cannot understand, interpret or do something useful with. It is so across all sciences. You build a model to answer a particular question, and you give it the necessary bells and whistles. The fact that most DSGE models did not include housing and bank liquidity is not a failure of DSGE modelling, it is a failure of recognizing what questions could be important in the future and this is damn hard to do properly.

Pesaran and Smith's solution to what they call the straightjacket of DSGE is to throw all these missing variables in a regression. Essentially, they want to bypass the discipline that theory imposes by letting the data speak. Again this is OK if you want to explore and find relationships, but this is not going to be very useful if you want to explain what is going on. Specifically, they advocate using vector autoregressions (VAR). As they complain that DSGE use representative agents when heterogeneity matters, they call for the use of data from several countries in the VAR, a rather strange argument, but I suppose this is because they are limited to aggregate data (and they neglect all the DSGE models using household level data...). In a statistical sense, the big problem is now that one quickly runs out degrees of freedom, as one has only so many time periods, and every additional variable eats degrees of freedom at a quadratic rate (times the number of lags). The other problem is that interpreting the resulting errors ("shocks") becomes difficult. One is then limited to vague notions like demand and supply shocks, much like in factor analysis. But at least Pesaran and Smith acknowledge that theory can be useful in selecting, say, long-term restrictions.

PS: I gave much of the same arguments in the discussion of a paper by David Hendry. Pesaran appears to be more knowledgeable of DSGE and is more willing to use theory to guide empirics. Unfortunately, Pesaran has the same habit of abusing self-citations, 12 out of 32.

Sunday, May 29, 2011

I find a recent opinion article on CNN by Michael Roth, the president of Wesleyan University, on the value of liberal arts education rather upsetting. I can understand that as the president of a liberal arts college he wants to defend this particular type of education. But his arguments ring particularly hollow, and I would have expected better from someone leading on of the best liberal arts colleges.

His selling points are the following. 1) A broadly-based education is better then professional or technical expertise. 2) Liberal arts develop critical thinking and creativity. 3) Focusing on science and engineering is a serious mistake. 4) Effective implementation of new technology requires social and economic understanding. 5) Scholarship in humanities increasingly requires scientists. 6) Flexibility is important on the job market.

I agree that an education can be too narrow. But the US liberal arts way of doing it is a waste. Undergraduate students spend less than two years worth in their chosen major, and most end up being functionally incompetent in their major as they graduate. I realize this is largely due to the fact that high schools failed to give them this broadly-based education as they water down requirements. But there has to be a better way. Send those who have not yet mastered the general education requirements to community colleges, for example.

If the US is the bastion of liberal arts, as Michael Roth claims, then he cannot claim it favors critical thinking. I am continually amazed how US students woefully lack in this regard, with few exceptions of course. They are not interested in what they are studying or the world outside. They are very passive and minimalist students. This is favored by the "anything goes" attitude that liberal arts favor.

The reason why the US is a world economic leader is that it has a scientific and technological edge, and that is has economic policies that provide good incentives, at least better than the rest of the world (and that Americans are obsessed with working). That edge is waning because other countries are catching up on the scientific and technological front and have already surpassed the US in several areas. Michael Roth apparently thinks it is wrong to try to keep that edge, and that one should focus more or social sciences, humanities and fine arts. He got the causation wrong. One can afford this when one is rich, but it does not make you rich.

I think he right on the fourth point. It is useless to engineer better crops if you cannot find a way for people to adopt them. But one does not need more liberal arts majors than scientists to achieve this. His fifth point actually shows liberal arts needs science, so science should not be discouraged.

I also agree with his sixth point. That is why one should have sufficient time to teach not just the recipes of a field, but also where they come from. This allows a student later to come up with new solutions to new problems. But the 3-4 semesters in a major do allow this. The result is that in fields where this is not sufficient students are not competent enough and end up with jobs outside their major and with low pay. Just look what pay is across majors. Liberal arts majors are consistently at the bottom, also due the fact that there are just too many of those students.

No, we should not encourage liberal arts education. This should be done in high school and community colleges. Let universities concentrate on the teaching of the core and produce truly competent professionals.

Friday, May 27, 2011

People are running scared about the relative increase of health care costs. As discussed recently, there a many potential explanations out there, my preferred one being that service goods that rely heavily on labor are bound to become relatively more expensive than manufactured goods that become cheaper to produce with technological progress. But one may also worry that this progress does the exact opposite for healthcare, if more technology makes it more expensive. Two recent papers look at the connection of technological progress and health care costs.

Justin Polchlopek wants to understand better medical technology and break away from using total factor productivity. Basically, he goes back to good old input-output modelling because he wants to avoid issues with capital aggregation that may matter. New technology in the medical sector is then equivalent to new capabilities in the model. Unless the use of existing capabilities is reduced, it is then obvious that efficiency will be reduced. This means that how new technologies are diffused and how they replace old ones is critical. Add in poorly designed insurance, and you have a recipe for disaster, but it can be largely reversed.

Amitabh Chandra and Jonathan Skinner take a very different approach, focusing on demand and supply. They use a more aggregate health care production function and study what determines health care productivity. They categorize three types of technologies: (I) highly cost-effective with little risk of overuse; (II) highly effective for some people/diseases; (III) uncertain treatments. Of course, focusing on (I) will increase productivity, while (III) is very costly for potentially little effect. The health care costs balloon if patients ask for the latest technology, which often falls into (III). Insurance systems, whether public or private, need to resist accommodating all such requests.

All in all, both papers show that new technology can become very costly if it is mismanaged. This can be corrected with insurance schemes that let patients feel in their pocketbook some of the consequences of their choices. Incentives through the budget constraint remain powerful disciplining devices.

Thursday, May 26, 2011

Many US states are currently tempted to increase sales taxes in order to overcome revenue short falls. While they should really be thinking about introducing a value-added tax instead, in the short run it is useful to study what the consequences of such a tax increase would be, not just on revenue, but also on economic activity and its composition.

Daria Burnes, David Neumark and Michelle White study the impact of higher sales taxes on retail employment at the local level. You think that higher taxes lead retailers to flee, but one should not forget that local authorities have other tools, in particular zoning. They find that in fact that locations with higher sales taxes have more retail employment, and that is because authorities than make greater efforts to attract big retail outlets. The downside is that manufacturing employment is getting crowded out by these efforts.

Wednesday, May 25, 2011

What determines demand for theater? Theater managers should be interested in understanding their market. Beyond this, this is also important for policy as theater is frequently and substantially subsidized. This the characteristics of those who go to theater and how frequently they do so may help understand whether it is worth subsidizing it. For example, if only rich people go to theater, one could leave the state out and let the public pay higher prices, which substitute for taxes (and would then improve efficiency). If it is mostly poor people who attend theater, then it may be worth subsidizing if there is some sort of positive externality from it.

Concetta Castiglione uses micro data from Italy to find results that are not very surprising: everything is driven by education and income. Rich educated people pay more taxes and get them back in part in theater performances. This is even more pronounced than for higher education, for which forceful arguments have been made that the state should stop subsidizing it.

Of course, all this ignores consideration about the supply. but that does not matter here. Demand should be essentially the same whether theaters are subsidized or not in Italy.

Tuesday, May 24, 2011

Health care costs are increasing faster than general inflation mostly everywhere, and for some time now. While this should not be a surprise, as health care is mostly a service good, there is considerable grief over the situation. Among initiatives to curb down costs are efforts on prevention, instituting copays and regulating health care providers. What about pharmaceutical drugs.

Begona Garcia Marinoso, Izabella Jelovac, and Pau Olivella report on a rather common practice in Europe: external referencing. This is setting a price cap on pharmaceuticals domestically based on what the price is abroad. This has obviously consequences on price negotiations in the foreign country, which is not too happy about this as the pharmaceutical companies are bargaining harder. But if the government can tie in drug authorizations into the negotiations, then prices are further capped and even the foreign country is not hurt. In other words, there is no reason that governments should give away bargaining power by putting price regulation and drug authorization in different agencies.

Monday, May 23, 2011

Entrepreneurship is the driver of growth and wealth, or at least an important driver. This is why so many initiatives are geared towards making life easier for entrepreneurs. And the champion in the US, with relatively little red tape, low taxes and especially very developed financial markets. One aspect that is much discussed right now is how low these taxes should be, especially as lowering them implies reducing some public benefits such as education. Is there a trade-off?

José María Millán, Emilio Congregado, Concepción Román, Mirjam van Praag and André van Stel use a panel dataset from several European countries to show that education matters for entrepreneurial performance, and it is not only the entrepreneur's own education, but also that of the workforce. An entrepreneur who cannot find appropriate workers or clients who are sophisticated enough for her products is not as successful. While the results are strong, I am a bit wary of using a short annual sample to tease anything out of education measures, but this is worth further investigation.

Saturday, May 21, 2011

One popular way to justify the introduction of monetary frictions in macroeconomic models is to assume that there is some cost associated to changing cash holdings, ATM fees or more generally "shoe-leather" cost. Whether these cost matter at all is controversial and settling this requires a two-pronged approach: first find empirically how large these costs are, and second demonstrate that the costs are large enough to matter in a reasonable model.

Alessandro Calza and Andrea Zaghini estimate the shoe-leather cost for the US. This is by far not the first time this is performed, by it can be worth it as data change, and in this case one can suspect that transaction costs indeed have gone down over a few decades. But there is one critical aspect that they take into account: most on US M1 is not held domestically, and this share has increased to currently 60%. Ignoring this seriously biases estimates, first because it overstates domestic demand and second because the shoe-leather cost stemming from inflation is largely borne by foreigners. At an inflation rate of 10%, the cost amounts to negligible 0.05% of total income. At lower inflation rates, it is even negative thanks to foreigners giving up real resources to acquire US money. In other words, you cannot build a monetary theory on this,

Thursday, May 19, 2011

It is conventional wisdom in policy circles that if you want a policy intervention to benefit children, transfers have to be paid out explicitly to the mother. The understanding is that mothers care more about their children than men, and thus are more likely to use the funds for them, directly or indirectly. There is really not reason to this backfire, but as two recent papers show, it can, in fact.

Matthias Doepke and Michèle Tertilt build a series of non-cooperative bargaining models of the household and show that things can go wrong with targeted transfers or women empowerment in general. Indeed, for transfers to have an impact on the intra-household allocation of public goods, there needs to be some kind on friction. The specifics of this friction have a large impact. For example, if women are hard-wired to prefer spending on children, then transfers targeted to them may lead to over-spending on children and under-spending on other public goods that also benefit children (say, shelter), reducing child welfare. Or: if the difference between men and women is in the market wage, women will naturally tends to more time intensive activities in the household, such as child rearing. Empowering women leads them to spend less time at home, hurting the children. If empowerment implies that women have access to more private goods (such as bars or entertainment), they will focus less on public goods that also benefit children. While these examples seem a bit convoluted, they highlight that things are not so simple.

Olivier Bargain and Olivier Donni show in another series of models with altruistic parents that targeted transfers may not work as well as targeted price subsidies. They demonstrate that price subsidies have an income effect and a substitution effect, something we teach undergraduates. But they reinterpret the substitution effect as a "targeting effect." Naturally, transfers only lead to an income effect. Thus subsidies are better at improving children welfare, but they are more expensive as they apply to everyone. So it all depends on elasticities, and depending on the situation, transfers or price subsidies could be preferred.

Wednesday, May 18, 2011

Sports and energy drink have become popular in the past decades or rather dubious grounds, as the recover and boost effect claimed in ads are in many cases false. See for example Vitamin water and Gatorade. In fact, plain water has much better recuperating properties than most of these sports drinks. And so does apparently chocolate milk, which has prompted marketing campaigns in the US with many athletes as spokespersons.

Senarath Dharmasena and Oral Capps, Jr. try to find the determinants of the demand for chocolate milk using a Heckman two-step demand model. Unfortunately, no regression results are presented, but the authors hint at a few interesting results. A quarter of all US households consume chocolate milk, with an average of 12 liters a year per household. Then they claim a number of household characteristics are significant, but with no indication in which way they are. For example, education of the household head is significant, and Hispanic household head as well. It would be interesting to know whether the relationship is positive or not. And as the authors ask in their title whether chocolate milk is the new-age sports drink, I am intrigued as how they could have answered this question. There is nothing in the paper itself about it.

Why am I reporting on such a thin paper? Because it always struck me how Europeans view adults drinking milk and especially chocolate milk as childish, while is it perfectly accepted in the US. I was wondering whether this difference could be seen in an empirical demand equation. Not in that one, though.

Tuesday, May 17, 2011

Growth is very unequal across the world. In some areas, the experience has been very frustrating, foremost in Africa, others have been booming, foremost dense areas like Singapore, Hong Kong, or Taiwan. From there, growth has spilled over to neighboring areas, the best example being Guangzhou next to Hong Kong. These areas all have in common that they are autonomous from the surrounding areas, either by history or by design. This has lead Paul Romer to push for charter cities as a new development concept in other areas: give a preferably coastal city autonomy from the rest of the state in its management, allow it to trade freely in goods with the rest of the world, and allow free movement of people. As these charter cities grow, they will eventually help the backcountry to grow as well.

This idea is met by some resistance, though. One is that this is once more the people from the North trying to impose a radical change in the way business is done. This sounds like colonialism all over again, but as Voxi Heinrich Amavilah points out, the concept of charter cities is precisely about imposing anything, letting the locals run the show as they wish. Also, the rents from trade remain local, as the locals are free to trade, whereas under colonization foreigners took the rents. I think the idea has merit, especially for areas where a failed state is a major impediment to progress.

Monday, May 16, 2011

Even before the crisis hit in the United States, there was talk about how foolish it is to get balloon mortgages, with low teaser rates for a few years. Yet people where going for them, either because they had expectations of strong income growth, or because they were time inconsistent or very impatient. Or people do not understand the true cost of the loan.

Johan Almenberg and Artashes Karapetyan document a phenomenon that is in some ways similar in Sweden. Mortgage interest is deductible from taxes for personal loans, but not when a co=op takes a loan. Yet people seem to favor financial situations that shift debt from personal to co-op loans. On average, the equivalent of US$540 a year are left on table. This can be explained by what is termed salience of debt. People only care about the costs they directly see, and the interest payments of the co-op are not itemized in the fees. The authors survey co-op apartment owners on how they think about their finances. It turns out people a very aware of their personal finances, but completely ignorant of the co-op finances. They never considered the trade-off between personal and co-op debt. That last point may indicate that ignorance may be more important than salience, though. This is reinforced by the fact that market price do not seem to reflect the tax difference.

Thursday, May 12, 2011

Teachers often find student evaluations rather frustrating. They are contradictory, short-sighted and sometimes insulting, especially when students did not put much effort in the class in the first place. Student evaluations are also biased towards teachers who are physically more appealing. And students, with their lack of experience and expertise, are not in a good position to evaluate an expert. What more could be said against student evaluations?

Michela Braga, Marco Paccagnella and Michele Pellizzari find that better teachers get worse evaluations. The way they measure teacher effectiveness is by looking at how students do in subsequent classes. They find that teachers matter, and substantially as the teacher can explain 43% of the standard deviation in subsequent grades. But the good teachers get a worse student evaluation, which is frightening, because administrators are getting the wrong message.

From the tables, I gather that higher ranked faculty teach better, but older and researchers with higher H-indexes do worse, which is rather contradictory. I wonder whether taking into account the obviously high correlation between some of the independent variables would take care of this, or other controls, like the attractiveness mentioned above.

Wednesday, May 11, 2011

A doctoral or PhD dissertation is supposed to be work that pushes the research frontier further. Obviously, not all dissertations are created equal and it is to be expected that some will push more that others. But they are all supposed to push. Well, do they? This is something that is quite difficult to measure as one needs to know where the research frontier lies and what the contribution of a dissertation is. For each dissertation, only few people can do this, and it is thus impossible to have an aggregate picture, unless you use a clever trick.

Sheng Guo and Jungmin Lee take publications in top Economics journals as the research frontier and look in which JEL categories they fall. They compare this to the JEL codes for US Economics dissertations and find a strong correlation controlling for the number of jobs available in the field. If you lag the publications by two years, the regression is just as good, which hints that dissertations react to the research frontier rather than the opposite (which is unfortunately undocumented), especially when you consider that with the long publication delays in Economics, the journals are in fact a few years behind the research frontier.

My interpretation here is not quite that of the authors, who really want to understand how students choose their field of study, given that they want to be on the job market with research on a hot topic. But when they start working on it, they do not know yet what will be hot. I am not sure this is quite such a conundrum, as seminars and conferences already give quite a good picture, and working papers as well. But it still looks like dissertations follow the trends instead of creating them.

Tuesday, May 10, 2011

Decisions of the Open Market Committee of the US Federal Reserve bank have long been scrutinized, both by market for obvious reasons and by academics. Some of the latter have even formed a Shadow Open Market Committee in reaction to the decision by President Nixon to impose price and wage controls in 1971, with the support of the Fed president. This committee has evaluated Fed policy and criticize Fed actions when due. But would it have done a better job?

William Poole, Robert Rasche and David Wheelock, who are all Fed employees, study how the policies advocated by the SOMC during the period of high inflation in the 1970s would have performed. Those policies where at odds with what the Fed was doing and even with what many academics were proposing. The policy rule was rather simple: reduce the target money growth rate by one percent every year, down to 4%. To evaluate this rule, you need a model, so they take the New-Keynesian model of Clarida, Gali, and Gertler (1999) off the shelf and run various experiments: one with the SOMC rule, one with the historic data (the Fed's action: a one time drop in money growth). While both policies eventually achieve their goal of reducing inflation, the SOMC one does so with less cost in output.

Now things are not that easy. To be fair to the Fed, it had at the time had rather little credibility, and it is not clear it could have gained any more credibility by adopting the SOMC's policy, as it requires some long-term commitment. Also, the Fed had to fight against attempts by Congress to take over monetary policy, and thus its policy choices were limited. And had the SOMC known that it policy would have been actually implemented, I am not convinced it would have taken the same choice. Indeed, it was rather risky, as it was at odds with what most other people were advocating. And markets may have reacted with incredulity to such an odd move.

Monday, May 9, 2011

The answer to this question seems rather obvious: those who get such education. Who loses? That is less obvious, and education has positive externalities on others.

Ana Balcão Reis says things are not that simple. First, we have to keep in mind that only few people are credit constrained when it comes to college tuition. Indeed, most of those who are do not make it that far in the first place. Second, those who benefit from public higher education are also those who pay the most taxes, thus the welfare benefit for them is ambiguous. To sort this out, the paper builds a model with different levels of education and agents differing by ability, human capital and the capacity of their parents to pay (which depends on their own human capital).

First think about the marginal agents, those who are the last one to go to public university. They would prefer not to have this option, that is, have only private universities and not pay the associated taxes. But because they have to pay them and college is now cheaper, they choose to get educated with little benefit. Those who do not go to college do not to pay taxes and would thus vote against public higher education. And the richest pay more in taxes than what they would pay in tuition. So all those left in favor of public universities are the not too rich who would go to college anyway. The question is whether they are a majority.

There is one important aspect missing in this analysis, though. Higher education has a positive externality on others: a more educated workforce raises everyone's productivity, and it makes it also easier to accumulate more human capital. This is only partially prices into wages, thus higher education needs some subsidies to reach efficient outcomes. Thus, a microeconomics analysis as performed here misses potentially important macroeconomic effects.

Friday, May 6, 2011

We all have regretted some decisions we have made. But different individuals respond differently to this. Some would say "oh well, I would have done differently had I known, but this is best I could do at the time." Others are more like "OMG this is horrible, you should not have told me." An individual of the second kind finds negative value in any ex-post information and thus wants to live in a world with a different information structure from the first.

Emmanuelle Gabillon formalizes this idea and studies structure where information is available before ("flexible") or only after ("non-flexible") decisions are taken. The paper also derives the characteristics a regret utility function should have (in particular, it cannot have "rejoicing"). Information can only have negative value in the non-flexible case if preferences exhibit concavity with respect to the ex post best outcome. Interestingly, information can also have negative value in the flexible case for a regretful person. Indeed, while information is useful for all people in revising the expected utility of strategies, for a regretful person it also is useful to revise expected regret. One can thus become even more conservative and this can lead to outcomes that are inferior in expectation to those where one would not have had the information.

Thursday, May 5, 2011

There is no mystery that under normal circumstances, homo oeconomicus does not play the lottery. Exceptions arise when there is enjoyment in playing the lottery (is this why slot machines a so popular in the US?) or when there are particular reasons. But casual observation indicates people play the lottery, and a lot. Maybe these circumstances mentioned above are met, maybe they are not rational economic agents.

Claus Bjørn Jørgensen, Sigrid Suetens and Jean-Robert Tyran would say lottery players, at least some of them, have a peculiar sense of probabilities. While many change their numbers, among those who change, many avoid numbers that have recently been drawn, as if the lottery were a drawing without replacement. But if a number is on a streak (drawn a few times in a row), then they choose it. If margins were not so high in lotteries, one could possibly make money by arbitraging against these people trying to predict the lottery numbers. But you can actually getting a positive return from lotteries by only buying tickets when large jackpots are at stake. The International Lottery Fund based in Australia is there to prove it.

Wednesday, May 4, 2011

Is seems to be common knowledge that attracting big sports events is good for business and especially tourism. I have never found this argument particularly compelling, after all it is mostly local residents who attend such events. And previous research I reported on gives me right: in the case of the Atlanta Olympics, the impact was very short-lived and limited to the tourism industry. But maybe there is more and better evidence.

Markus Brückner and Evi Pappa take a different approach form the traditional impact study: they look at macroeconomic aggregates and focus on the anticipatory effect during the bidding process for the Olympic Games. The fact that a country is bidding gives people an indication that aggregate demand may increase in the future, especially if the country is selected into the last set of candidates. This anticipation can increase economic activity right now. Brückner and Pappa study a panel of 184 countries over 57 years. They find higher GDP growth during the five years before hosting, peaking at four years when the next host is announced. As expected, the impact fades quickly for unsuccessful bidders. And results are robust for World Exhibitions, but strangely reversed for Football World Cups. In all that, I wonder whether bidding for such large events is in fact exogenous. Indeed, you only want to bid if you have a healthy economy, especially if the event is large like the Olympic Games.

Tuesday, May 3, 2011

Should banks be allowed to do business across borders? The answer is not obvious. For one, it is beneficial that they have the opportunity to better diversify their risks, but they can do this without having to open branches in other states or countries. The counterpart is that doing business elsewhere increases opportunities for adverse shocks. Finally, regulatory competition in an international banking market leads to a large systemic risk.

Dirk Schoenmark and Wolf Wagner try to sort this out in the case of Europe and come to the conclusion that it depends. They argue that Germany and the UK are well diversified and thus can sustain cross-border banking, even though there appears to be overexposure to the US, as exemplified by the large negative consequences in Europe of the recent crisis in the US. For the countries on the fringes of Europe, though, there seems to be very poor diversification. Indeed, these economies seem to be very dependent on a few large foreign banks, and consequences could be dire if they run into difficulties or decide to pull out.

This analysis is entirely based on asset shares and thus diversification. This neglects a major advantage of foreign banks: they bring lending capital that would otherwise not be available. The case for cross-border banking is thus understated in this paper.

Monday, May 2, 2011

A basic principle in Economics is that of comparative advantage: a country will produce the goods that it is relatively better at producing, even it is bad at it. The traditional story usually includes relative endowments in capital and labor, and the capital intensity of goods matters. Now add environmental externalities. Comparative advantage would say that polluting production should take place were pollution is the "cheapest," that is. where it would have fewer consequences. This is the principle being the introduction of an international market for pollution rights. Such markets are already active within countries, with the idea that firms that can best control pollution will produce the polluting goods, as they need fewer pollution rights. Would this basic principle also hold across countries?

Jota Ishikawa, the late Morihiro Yomogida and Kazuharu Kiyono claim that it is not necessarily beneficial to have an international market. Indeed they point out that rich countries could import pollution rights from the poor countries, thereby further deteriorating the environment in the developed economies. So instead of relocating production, pollution is imported. It all depends on comparative advantage.